Issues on Taxation of LLP. CA Suhas P Bora

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1 Issues on Taxation of LLP CA Suhas P Bora Pune Branch of WIRC had organized the Direct Tax Refresher Course in which a session on Taxation of LLP was held on 28 th May The paper was presented by CA Milin Mehta from Vadodra and the Session was Chaired by CA Suhas P Bora. There were many issues raised on the Taxation of LLP for which replies have been given by Chairman CA Suhas Bora, which are as under: 1. Maintenance of Books on Mercantile basis under LLP Act, and Cash basis under Income Tax Act, An LLP shall be under obligation to maintain annual accounts reflecting true and fair view of its state of affairs. The accounts of the LLP shall be audited in accordance with Rule 24 of LLP Rules Sec. 145 of the Income Tax Act, allows assessee to employ Cash System or Mercantile Systems in respect of Income chargeable under the head "Profits and Gains of business or profession or Income from other sources. The choice of Method of accounting is left with the assessee and it is not choice of A.O. The Income tax Act, does not provide that Return of Income should be based on audited accounts under LLP Act, 2009 and further that the income will be computed as per Profit and loss account prepared as per LLP Act. There is no provision or section in the LLP Act 2009 or Income Tax Act 1961 which provides that LLP cannot have cash system of accounting as allowed in Sec.145 of the Income Tax Act Thus LLP can maintain the books of accounts on Merchantile basis under LLP Act and cash method for Income Tax Act In support of this, reliance is placed on the following decisions. a. DCIT Vs M/s Stup Consultants Pvt Ltd. ITAT Mumbai - (5 Tax Corp (A.T) b. Cyber Media India Ltd Vs CIT and Anr 338 ITR 177 (Delhi) c. Amarpali Mercantile (P.) Ltd Vs Assitant Commsioner of Income Tax - 45 ITD 386 (Delhi) d. Chenai Finance Co. Ltd Vs Asstt. CIT 81 ITD 7 (Hyderabad)

2 2. Income under Presumptive Taxation u/s 44 AD of the Income Tax Act, Section 44AD is applicable only to Individual, HUF and Firm, and LLP is not included, on the contrary it is specifically excluded, therefore an LLP cannot avail of the benefit of the provisions of Section 44AD of the Income Tax Act Section 44AE of the Act contains special provisions for computing profits and gains of business of plying, hiring or leasing of goods carriages. The Finance Act (No. 2), 2009 has not amended Section 44AE and therefore LLP can offer income u/s 44AE subject to satisfying other conditions and can avail the benefit thereof. 3. Whether Quantification of Remuneration payable to each Partner is must : Reference should be made to CBDT Circular No. 739 dated ITR 131 (ST). In the said circular the board has clarified in Para 4 about the conditions for allowability of Remuneration. As per this circular for claim of remuneration to the partners following two conditions need to be complied with:- a. Partnership Deed should either specify the amount of remuneration payable to each individual working partner, or b. Lay down the manner of quantifying such remuneration. Therefore if Partnership Deed provides how remuneration is to be worked out, subject to maximum permissible amount as per provision of section 40(b) of the Income Tax Act, 1961, and how it is to be distributed amongst the working partners, then it satisfies the requirement of the Section and therefore quantification of remuneration for each partner is not required. In this regard, reliance can be placed on the Decision of Himachal Pradesh High Court in case of CIT Vs Anil Hardware Store 323 ITR Disallowance of Remuneration u/s 40A (2) (b):- On reading of Section 40(b), it is clear that Legislature has not only allowed deduction of remuneration to be paid to the partner but also laid down the limit and extent to which it can be paid. The intention is not to restrict but to allow maximum amount as prescribed and therefore there is no scope for the Assessing Officer to go into the question of reasonableness of remuneration paid to the partner. However he can verify the following conditions for allowability of remuneration to the partners: a. Partner is working partner b. Payment of remuneration should be authorized by the partnership deed for the period for which the remuneration is claimed. c. Remuneration should not exceed the amount provided in the provision.

3 In support of the claim of remuneration to the partners being within the limits prescribed under section 40(b) reliance can be placed on the following decisions and CBDT Circulars : - a. Chajjed Steel Corp Vs ACIT 77 ITD 419 b. CIT Vs Great City Manufacturing Co ITR 156 (All) (HC) c. Old Circular No. 6-P (LXXVI-66) of 1968, dated gives guidance to officer in respect of applicability of Sec 40A (2) (b). Intention was to check the tax evasion when the payments are made to relatives and not to harass the assessee. d. Circular No. 696 dated , explains the provisions of the Finance Act, 1992 of Para 49.7 giving assurance that no disallowance of remuneration to partner can be made u/s 40A(2)(b) in respect of small firms. Though this circular is not very clear still the assessing officer who invokes these provisions has to keep in mind the assurance given finance minister in his speech dated in parliament during the budget discussion regarding apprehension about the provisions of section 40A(2), wherein he has categorically stated that the CBDT will be asked to issue instructions to the assessing officer so as to ensure that the power is not used in case of small firms and even otherwise, it should be used sparingly 5. Share of Profit from Foreign LLP:- Section 10(2A) of the Act defines that a person being a partner of a firm, who has received the share in the total income of the firm which is separately assessed and Section 2(23) defines the firm which includes LLP as defined in the LLP Act, 2009, therefore Share of Profit from Foreign LLP is not exempt u/s 10(2A) of the Income Tax Act, Applicability of the provisions of Section 14A of the Income Tax Act, Prior to insertion of Section 14A, it was settled that when the statue has, by fiction, provided that the remuneration received by the partner from the firm is to be assessed under head Business or Profession, any interest paid by the partner for the purpose of earning the remuneration must also be deducted. But now section 14A restricts the allowance of any deduction towards any expenditure incurred towards in relation to any income which is exempt from tax. Therefore it can be claimed that since remuneration received from the partnership firm is not exempt from tax, the interest paid on borrowed capital is to be allowed, however honorable ITAT Mumbai Bench in the case of D.J. Mehta Vs ITO ITD 527 held that interest on borrowed capital cannot be allowed against the remuneration received from the firm as there was no nexus between borrowed capital and the remuneration earned as the remuneration is received by the partner, who is working partner and who has provided the services to the firm.

4 Similarly there is another decision of honorable Mumbai bench in the case of Sudhir Dattaray Patil Vs DCIT 2 SOT 678, wherein it is observed that the share of profit derived from the firm is not subject to tax in hands of the partner and if it is so then automatically the provisions of section 14A come to operation. However, in this decision honorable bench at Para 9 also held that the assessee is entiltled to deduction of interest paid on monies borrowed for investment in the firm in which he has become a partner against the amount which is received by him from the firm as remuneration / salary and assessed under the head business. In support of this conclusion the honorable bench has relied upon the decision of Supreme Court in the case of CIT Vs R. M Chidambaram Pillai 106 ITR 292 and ITAT decision in case of Santosh Kumar Agrawal Vs ACIT 78 ITD 394 (SMC) 7. Realignment of Profit Sharing Ratio in LLP:- Normally realignment of the profit sharing ratio is made in following two situations:- i. At the time of admission, retirement of the partner. ii. In the existing firm due to changes in the terms and role of the partners. In the partnership firm or LLP, no definite interest is defined, therefore it does not amount to transfer and not liable to capital gains tax. However if the incoming partner makes payment to the existing partner for obtaining the share of other partners then it will amount to transfer of Capital Asset and liable to tax in his hands if the consideration is more than the value of his share. In this context, Pune ITAT decision in the case of Shevantilal Mehta is to be kept in mind while drafting the clauses of partnership deed. 8. Amount received at the time of Retirement:- Surplus received from the firm on pure retirement of the partner is not liable to tax, since it is a capital receipt. In this context, reliance can be placed on the decision of Supreme Court in the cases of Mohanbhai Pamabhai 165 ITR 166, CIT Vs Hind Constructions Ltd 83 ITR 211 and CIT VS Lingamallu Raghu Kumar 257 ITR 801 wherein it is held that such surplus is not taxable. On the other hand, if the claims of the outgoing partner were settled on an adhoc basis without proper preparation of the accounts and such settlement was done by lump sum payment, then this would result in the capital gains in the hands of outgoing partner. This contention is upheld in the following cases a. N.A.Modi Vs CIT 162 ITR 420 ( Bom) b. Tribhuvandas G Patel Vs CIT 236 ITR 515(SC) c. Bishanlal Kanodiya Vs CIT 257 ITR 449 (Del)

5 9. Revaluation of Assets and Credit to Partners Capital Account, whether interest at 12% on such enhanced amount is allowed:- Interest on Capital is allowable if the conditions of section 40(b)(iv) are complied with, subject to the terms and conditions of the partnership deed. When the interval between the withdrawal from the reserve account and the deposit of the withdrawn amount is short, the assessing officer may infer a tax avoidance device and may go ahead and pierce the veil and make the enquiries thereof. Thereafter the AO will decide whether the business of the firm required the additional capital or whether the same was brought in only to claim deduction of interest from its taxable income. In the case of ACIT Vs Sant Shoe Store 88 ITD 524, the honorable ITAT Chandigarh bench has decided this issue in favour of the assessee on the following grounds by relying upon the decision of honorable Supreme Court in case of Sunil Siddharthbhai Vs CIT 156 ITR 509 and N Khadervali Saheb Vs N. Gudu Sahib (261 ITR 1). a. Assessing Officer has no power re-write the books of accounts of the firm. b. Interest has to be allowed as computed by assessee, if it is within limits of Section 40(b) (iv). c. It is authorized by and in accordance with partnership deed. d. AO is not entitled to make adjustment in the profit and loss account or in the capital accounts of the partners. e. The interest is taxable in the hands of partner. 10. Applicability of Section 40A (3) of the Income tax Act, 1961:- The payment of Interest and remuneration to the partners is allowed as a deduction and is treated distinct from any appropriation of profit as it is not added back in hands of the firm. In this scenario the amounts are outgoings as expenditure and section 40A (3) may be attracted. However if such remuneration or interest credited to partners capital account first and then the partners are withdraw, in this scenario the amounts withdrawn by the partners will be considered as withdrawals from the capital account, and therefore applying the provisions of section 40 A(3) will not arise. In the scenario of remuneration is transferred to remuneration payable instead of capital then the provision of Section 40A (3) are applicable if later on the payments are effected in cash. Therefore it is advisable for the firm/llp to credit such amounts first to capital accounts of the partners and thereafter to allow withdrawals to the partners.

6 11. Provisions of MVAT Act, 2002 in case of conversion of Partnership to LLP and visa-versa and conversion of Company to LLP and visa-versa:- The process of conversion of Partnership to LLP and visa-versa and conversion of Company to LLP and visa-versa shall be termed as change in constitution. As per provisions of Section 16(6) the dealer whose business is discontinued due to change in the constitution has to apply for cancellation of old registration within 30 days and newly constituted dealer has to apply for new registration as per Sec 16 and Rule 8 within 30 days from the change in constitution. If the dealer applies for the cancellation and new registration within the prescribed due dates the principle of going concern will apply and the business assets and liabilities including stock on the date of transfer will be continued in the new concern without any impact on tax liability. In case of delay in the application for registration, the going concern principle will not apply because the old entity stands ceased and will be deemed to be cancelled from the date of change of constitution and new entity will be registered from the date of application for registration. The intervening period will be the URD period and assets and the assets transferred during the URD period will be liable to tax at the book value in the hands of selling dealer (old constitution) but the purchasing dealer (new constitution) will not be liable for set off since on the date of transfer it is URD. Further, as per the provisions of Section 44(4) there exists a joint and several liability between the old and new constituted entity, in case of change of constitution, for payment of tax, interest, penalty, sum of forfeiture, etc. Disclaimer:- The information and views expressed in this article are solely those of the author in his individual professional capacity and do not necessarily reflect the official opinion or views of departments of tax laws in India. The author has expressed his views relying upon the tax laws, judgments and circulars in force at the time of publishing this article which may be amended later on.